To properly plan and manage finances, organizations need to monitor their budget allocations. This practice will help management identify their current level of resources and how much they can spend on a department, project, or inventory.
With full visibility into allocation limits, businesses can ensure that expenditures do not exceed revenue and profitability is maintained.
What is Budget Allocation?
Budget allocation is when an organization allocates the maximum amount of funding they are willing to spend on an activity or program. Essentially, it is a limit that employees cannot exceed when charging expenses.
Organizations will create a budget with consideration of the expenditures from the previous year. Managers will also estimate how much revenue they expect to have in the upcoming year so they can identify the level of resources they will have available. This helps them to take into account all the needs of the organization and how they can best allocate their money.
The goal of budget allocation is to ensure that a company's resources are efficiently and effectively used. It also helps management make informed decisions to protect the business's bottom line.
4 Steps of Business Budget Allocation
Successfully budgeting can help organizations guarantee that they have the funds necessary to meet obligations, as well as enough resources to deal with emergency situations.
Businesses can improve their budget allocation by following 4 key steps.
1. Identify Spending Requirements
Management teams should outline all of the expenditures and financial obligations they plan to cover with their budget. These areas of spending usually include staff salary, inventory, and supplies.
2. Determine Methods of Funding
To ensure that expenditures are paid, businesses must determine how they generate or locate revenue. For existing companies, this can be through sales, while new brands will typically depend on investments. The revenue is then split and assigned to various budget items.
In the case that the organization does not have enough resources available, executives will have to return to the first step and make cuts in the amount of money they want to spend on a budget item or remove the item in its entirety.
If a budget item is necessary and vital to an organization's business plan, management should find new ways to produce more revenue.
3. Execute the Budget
At this stage, the budget has been thoroughly planned and businesses can start spending the funds they allocated for the different items in the budget.
Oftentimes, circumstances may arise that require managers to make changes to their budgets. Businesses that experience this should conduct a thorough review of their resources to make sure they have enough funds to meet all needs.
4. Monitor and Maintain Budget Allocations
Finance teams should regularly monitor budget allocations to make sure that the business is following established spending plans.
It is helpful to create a spending record to allow managers to assess all purchase orders and bills, and compare them to budget allocations. Recording spending will also promote accountability by enabling executives to check whether procurement activities were done correctly.
Additionally, it can help the organization with future budget planning and can highlight any saving opportunities.
Direct and Indirect Costs in Budget Development
When developing a budget, management needs to classify their different expenditures into standard budget categories. These two classifications are-
Direct costs refer to expenses that are directly tied to a project or production of a product or service. This includes using funds for raw materials, labor, and distribution.
The most common direct costs a business will encounter are-
- Personnel - These are costs related to employee salary, holiday pay, and health insurance.
- Allowance for Travel and Subsistence - This refers to round-trip airfare, lodging, meals, and transportation expenses.
- Vehicle - Typically, vehicle costs, such as renting and maintenance, will be included in the travel and subsistence item. If employees or managers drive their cars for business purposes, they can claim a certain amount per mile.
- Consumables and Supplies - This includes money reserved for supplies and activities to complete a project. Some of the most common consumables are software, stationary, and batteries.
Indirect costs are expenses that are not related to the production of a good or service. Also referred to as overhead expenses, this type of cost cannot be simply traced back to a project, product, or activity.
For example, the most common forms of indirect costs are-
- Utilities - Expenses for electricity, gas, and water are the main costs of operating and maintaining buildings and warehouses.
- Premises Rent - Businesses will typically have to pay their monthly or yearly rent to continue working in their office or to operate their brick and mortar locations.
- Depreciation of Equipment - When equipment and machinery wear out and become obsolete, they lose value.
- Security Expenses - Some offices and warehouses will employ security guard personnel or systems to ensure the safety of inventory and employees.
By thoroughly understanding the various expenses an organization must cover, management teams can develop effective budget allocation and ensure smart spending decisions.